The Question Every Goldman Client Is Asking: ‘Is An Equity Correction Imminent?’

You’re a Goldman client.

Ok, no you’re not.

But let’s pretend.

What is it you’re thinking about these days? Well as it turns out, you’re thinking the same thing everyone else is thinking (with the possible exception of Target managers-turned hedge fund titans buying XIV on dips with other people’s money). Namely, you’re thinking this: “Is an equity correction imminent?”

I mean “yes”, the central bank put is still firmly in place and that means the BTFD mentality is still deeply entrenched, as are the feedback loops the BTFD mentality fosters, the same feedback loops that make multi-millionaires out of former Target logistics managers and the same feedback loops that make it impossible for active managers to generate any alpha.

That said, the fraught political backdrop and escalating geopolitical tension stands in stark contrast to suppressed cross-asset volatility and stretched multiples, leading rational people to wonder whether Wile E. Coyote has run off the cliff.

Now again, you probably don’t care about this if you’re a retail investors but just in case you want to know what institutional clients are asking, read more from Goldman below…

Via Goldman

The question every client asks: “Is an equity correction imminent?” The impetus for the inquiry comes from several sources:

1. History. Many investors argue the bull market is “long in the tooth” and will soon come to an end. It has been 14 months since the S&P 500 index experienced a 5% sell-off and 19 months since the market had a correction of 10%. The last bear market defined as a fall in the index greater than 20% ended in 2009. The current bull market has lasted for 8.5 years and the S&P 500 has climbed by 260% compared with a 124% rise in earnings and a 64% P/E multiple expansion to 18x forward EPS.

2. Volatility (or lack thereof). Realized 3-month vol is nearly the lowest in 50 years. Implied vol as measured by the VIX stands at 12, a 6th percentile event since 1990. In his recent book, Tectonic Shifts in Financial Markets, the legendary Salomon Brothers economist Henry Kaufman (with the superb sobriquet “Dr. Doom”) references the lesson of Sherlock Holmes in “The curious incident of the dog in the night-time” that what doesn’t happen matters as much as what does. Low volatility across asset classes may be masking risks that are not evident today but will be obvious in retrospect.

3. Valuation. Equity valuations are stretched on almost every metric. The typical stock trades at the 98th percentile and the overall index at the 87th percentile relative to the past 40 years. Only on a Free Cash Flow (FCF) yield basis is the market valued at an average level (4.4%). But as we detailed in a recent report, the collapse in capex spending explains the FCF yield. On a cash flow from operations basis the market trades at the 87th percentile. Other asset classes are also highly valued vs. history: nominal Treasury yields (92nd), real yields (75th), and HY (75th) and IG (69th) spreads.

Valuations

4. Economics. The current US economic expansion just celebrated its 8th birthday making it one of the longest stretches without a recession. Only the 10-year expansion during 1991-2000 and the 9-year expansion from 1961 to 1969 had longer durations. The median length of the 16 expansions since 1921 has been 42 months. Along with the question about an equity correction, another frequent inquiry is “when will the next recession occur?” Our economists assign an 18% probability of a recession within 12 months.

5. Fed policy. The FOMC has lifted the funds rate by 100 bp since it started tightening in December 2015. During prior hiking cycles, equity P/E multiples typically fell but multiples have actually expanded during the past two years. Futures imply one hike by year-end 2018 vs. our economists’ estimate of five. The uncertain pace of further tightening is a cause of much investor anxiety.

FedStocks

6. Interest rates. Two months ago, Treasury yields equaled 2.4%, ten-year implied inflation was 1.7%, and the S&P 500 stood at 2410. Our year-end forecasts of a 2.75% bond yield and a 2400 level in the S&P 500 looked rational. However, weaker-than-expected inflation data sparked a 35 bp drop in bond yields to 2.05% and a 2% stock market rally to 2465 (+10% YTD). Looking ahead, we maintain our year-end 2017 target (-3%).

7. Politics. President Trump’s fluid positions on domestic policy disputes in Washington, D.C. and geopolitical gamesmanship with Pyongyang and Beijing make political forecasting a precarious activity. One fund manager cited the “Law of Conservation of Volatility” under which there is a finite amount of uncertainty in the world. All the risk is now concentrated inside the Beltway and volatility outside of politics is close to zero. Of course, this could change at a moment’s notice.

Investors cite the points above to justify their forecast of a looming correction. According to their narrative, high valuation leaves little room for error. A Fed tightening despite low inflation will spark concerns about the sustainability of economic expansion and lead to a jump in vol that may be compounded by a political event that in turn will spark a wave of selling.

As factors reverse performance, quant funds will liquidate positions putting additional downward pressure on share prices and driving indices lower.

Although the preceding sequence of events could happen, we view it as a low probability event in the near-term for two key reasons: First, investors are not complacent. In Sir John Templeton’s timeless observation, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Investors today are situated between skepticism and optimism. Few are euphoric as 27% of core managers are beating their benchmark. “Tormented bulls” best describes investor mentality. Alpha-seekers have normal cash positions (3.2% of mutual fund assets), active manager redemptions are offset by beta inflows (ETFs), and corporates continue to repurchase shares. Second, US economic growth persists led by consumers that account for 69% of GDP. Monthly job growth has averaged 175K YTD, wages are rising (our leading indicator is a 2.7% rate), confidence is at the highest level since 2001, and household balance sheets are the strongest since 1980. For corporates, S&P 500 sales and EPS will rise by 5% and 7% in 2018.

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6 thoughts on “The Question Every Goldman Client Is Asking: ‘Is An Equity Correction Imminent?’

  1. The Coyote was just handed an anvil by the Road Runner…
    but, then again, the whole thing is a cartoon at this point – defying gravity and reality.

  2. Dudes who lost all betting against China: Kyle Bass, Jim Chanos, Gordon Chang (author of The Coming Collapse of China, published in July 2001) and Mark Hart (bankrupted after losing $250-million since May on leveraged yuan shorts, now and an activist in the Fight For 15 as going to work for McD’s). LOL

    1. Highly amusing IRB, “Mark Hart (bankrupted after losing $250-million since May on leveraged yuan shorts, now and an activist in the Fight For 15 as going to work for McD’s).”

      1. Some artistic license with the McD’s… gawd help us if he/me ever had to get a REAL job.
        I worked at a busy McD on the grill when I was 16, and it was harder than trading, haha.

  3. Yea, is it thin ice or thick ice?
    You ( they ) placed their bets in the casino.
    Nobody will know till the algos come to life.
    Till then, take it slow and rely on experince (s).

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